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Unintended Effects of Progressive Taxes

Virginia Postrel links to a Daniel Weintraub column that points out an unpleasant side-effect of a progressive tax system:

The rich are no longer getting richer in California. And the rest of us, oddly enough, are suffering from their misfortune.

That’s the story from the latest report on tax returns filed for the 2002 tax year. The preliminary figures, which I obtained from the Franchise Tax Board last week, show that the number of returns reporting incomes exceeding $1 million dropped again, to about 25,000. The combined income earned by those fat cats also shrunk, by more than 20 percent.

Why should we care?

Because California’s skewed income distribution, combined with progressive tax rates, means that the people at the very top of the income heap pay a very high percentage of the personal income tax collected in this state.

Their extraordinary, onetime income surge at the end of the last century provided most of the new tax revenue that legislators and former Gov. Gray Davis used to raise teacher salaries, increase welfare benefits and expand eligibility to state-provided health care. But the decline that followed also accounted for most of the revenue drop that contributed to the state’s fiscal crisis. And as of the most recent tax year, they hadn’t hit bottom yet.

Emphasis mine. A similar notion (at the federal level) was brought up in The Wall Street Journal in a column by Alan Murray (subscription required) via Brad DeLong. Murray is critical of all of the Democratic presidential candidates’ tax plans which, predictably enough, all focus on raising the top tax rate:

But raising the top tax rate to 45% is both bad policy and bad politics. As a political matter, one of the charms of American voters is that while few make more than a million dollars a year, many think they might in the future. As a policy matter, marginal tax rates… do have an important effect on economic incentives. Moreover, boosting the top tax rate is an open invitation to tax lawyers and investment bankers to devise clever ways to hide clients’ income, or transform it into capital gains…

The former Clintonites who advise Democratic candidates on tax policy point out that President Clinton raised the top tax rate to 39.6% from 31% — and the sky didn’t fall. Instead, the economy went on to an unprecedented period of growth. Entrepreneurs, who arguably are most influenced by the disincentives of a high top tax rate, flourished.

But does that mean the top rate should be boosted ever higher? Hardly. Democrats who say marginal rates don’t matter are the equivalent of Vice President Dick Cheney, who, according to former Treasury Secretary Paul O’Neill, said deficits don’t matter. Both statements are dangerous oversimplifications. And together, they show why so many Americans fear a government dominated by either political party.

The Democrats call their fiscal gymnastics “tax reform,” but it’s almost the antithesis of the tax reform of 1986. That was a bipartisan effort, based on the notion that there was some good (and some bad) in what both parties were peddling. Republicans, concerned about growth, wanted to lower marginal tax rates; Democrats, concerned about fairness, wanted to eliminate special-interest loopholes and tax shelters. The result was a law that did both…. If Democrats want to adopt the reform label again, they should follow the same path. Instead of raising tax rates, they could focus on eliminating loopholes for the affluent and broadening the tax base.

Emphasis mine. Liberals often complain of how Republicans, like Dubya, are always pushing tax cuts for the rich. I can understand that it can seem like an attempt to widen the wealth gap and help move us to a caste society (and perhaps that was even the motivation behind Dubya’s tax cuts). However, given that the rich are always the first to get tax increases, it actually seems fair to me that they be the first to have those increases rolled back.

And California’s budget crisis is a big reason you want a broader base of revenues. In other words, a flatter tax. And I fail to see why a progressive tax is fairer than a flat tax anyway.

Personally, I’d like to see all the deductions and exemptions and brackets removed. Yes, including the mortgage deduction, even though I benefit from that personally (but really, the deduction is not there because of homeowners — it’s there because it inflates home prices by increasing demand and thus increases the commissions for the real estate industry). In my mind, taxes should have one purpose, and one purpose only: raise revenues (indeed, many libertarians think we should eliminate the federal income tax altogether). The tax code is no place for attempts to influence social behavior — such attempts always have unintended consequences anyway (note that it’s a different issue when you’re using taxes to compensate for shared costs, such as pollution, that would otherwise be ignored). And certainly no place for socialist transfers of wealth.

Indeed, tax brackets are exactly why we can’t get rid of the marriage penalty. Dealing with marriages is easy with a flat tax: income is income, and is all taxed at the same rate no matter how many wage earners are in a household. Let’s assume a 25% flat tax rate. If someone making $60,000 marries someone making $80,000, separately, they’d pay $15,000 and $20,000 respectively for a total of $35,000. Married, they’d have a household income of $140,000 and would still pay $35,000. For a single-income household, the tax paid before and after marriage is also exactly the same because the income level doesn’t change at all.

Once you have brackets, then it becomes impossible to maintain fairness to dual-income households. Such a system is inherently skewed to favor single-income households, because with two incomes, there is always a chance of the marriage bumping you into the next bracket (unless the bracket cutoffs were outright doubled for married households, which then just amounts to a tax cut for single-income marriages).

Which is always how it happens. Even when the government has the best of intentions, there are almost always undesirable unintended consequences. Which is why libertarians believe that the less the government does, the better. Incidentally, the very same reason Star Trek had the Prime Directive, and a reason some liberals cite in their opposition to the Iraq invasion.

Update 9/28/04

My observations about the progressive tax and the marriage penalty is apparently the same conclusion reached in the paper, “Policy Watch: The Marriage Penalty” by Alm, Dickert-Conlin, and Whittington. Unfortunately, it’s only available to download for AEA members. Grrr!